The Road to Global Monetary Debasement

In today’s Markets and Money, we’re going to look at China’s recent ‘monetary easing’ and show you why it’s not as straightforward as it looks.

But first, some local news…

The Aussie market is on a tear. Today’s gain marks the 12th straight rise in the ASX 200 index, which I think sets some kind of record for consecutive daily gains.

The stock market is turning into some weird sort of bond market, where everything is assessed on yield first and actual fundamentals second. That’s good for now, dangerous later…

You can’t argue with the price action though, even if you disagree with it. The ASX 200 broke out to a new, post 2008 high on Tuesday and has kept going. This suggests that we’re set for another leg up in the bull market…after pretty much going sideways for a year.

Of course, you don’t get 12 straight rises (and a gain of nearly 550 index points in little more than two weeks) without giving some of it back to profit taking in subsequent weeks. But the bulls are firmly in control here. Thanks to the market having more faith in central bankers than they do in God, the bulls look like they’ll stay in control for the time being.

One bloke who isn’t in control is Tony Abbott. He’s lost his grip big time. The Fairfax media reports this morning that Malcolm Turnbull sought a meeting with Abbott, apparently to find out exactly how Tony was going to get the party back on track.

Who knows what went on? And you certainly wouldn’t believe a word of their public utterances. What’s clear is that Abbott is bleeding profusely and the sharks are swarming.

Next week looks like it will a crucial one for his leadership. If the Liberal Party had any brains, they’d promote Malcolm Turnbull, as he has the greatest chance of appealing to the marginal Labor voter. But the Liberal leadership is full of right wing ideologues following an anachronistic, conservative agenda.

In other words, they’re all foaming-at-the-mouth idiots who are completely out of touch with most of Australia. The only reason Abbott won power was that the other side was less than useless. That’s how politics seems to work these days…you win office based on the weakness of your opponent, rather than your strengths.

Isn’t it funny how the quality of leadership and of politics in general in this country has deteriorated along with the economy? With economic conditions set to get even worse in the years to come, does this mean we have to put up with more political pathetic-ness?

Chances are the answer is yes. Great leaders generally emerge out of times of economic hardship. Just like an addict needs to hit rock bottom before they take the necessary steps to recover, so too an economy needs to go through tough times before the majority of people wake up and demand genuine change.

You could draw the same parallel with what’s happening on a global scale. Our reverence of central banks and money printing will only be exposed as false once their policies basically destroy the system.

It’s abundantly clear that cheap money is a cancer on the economy, that it destroys the value of money (in relation to asset prices, if not consumer prices) and that it simply doesn’t work.

But we’re so far down the road in this monetary experiment that to stop now would be akin to going cold turkey halfway through the party. Cold turkey only works once you’ve hit rock bottom. That’s when the will to change is greatest, and not a minute before.

So we’re on the road to global monetary debasement…first against asset prices and then against everyday goods and services. The latter could take another few years though…

In the meantime, sit back and enjoy the central bank show. If you want to profit from it, here’s an intriguing way to do so. My mate Tim Dohrmann, editor of Australian Small Cap Investigator, has found a number of stocks that allow you to ‘invest like a millionaire’. Click here for more…

The latest central bank to try and ‘do something’ is the People’s Bank of China (PBoC). Although it is hard to keep up; the Danes cut interest rates last night for the fourth time this year in a futile attempt to maintain their peg with the euro.

That’s partly the reason behind China’s latest move too. I wrote here a few weeks ago that I thought the yuan/US dollar peg would be the next to go…another casualty of the global currency wars.

This week, the PBoC lowered the amount of reserves that banks are required to hold against its deposits, which frees up around 500 billion yuan for potential new loans.

The mainstream media hailed this as monetary easing but in the scheme of things, an additional 500 billion yuan in loans is tiny. Look at the Chinese stock market’s reaction…it fell on the news.

To see why this news might not be so bullish after all, you have to understand the effect of the yuan/US dollar peg.

The initial pegged exchange rate undervalued the yuan, which lead to China generating massive trade surpluses and foreign exchange reserves.

What many people don’t realise is that those reserves form the backbone of China’s financial system. They don’t sit on some vault somewhere, available for a rainy day when China really needs them. Not exactly, anyway.

Here’s how it works, roughly…

When US dollars flow into the country, the PBoC must print yuan to maintain the exchange rate peg. The dollars go into the foreign exchange vault, and the newly printed yuan go into the Chinese banking system as commercial bank reserves.

Just think of it as double entry accounting. On the one side, you have an asset (the FX reserves) and on the other you have a liability, which are the domestic banking reserves.

As these assets and liabilities grew (thanks to the pegged exchange rate), China had to do something to stop all the newly created bank reserves flowing into the economy and leading to an inflation blow out. So they started increasing the reserve requirement. That is, they made banks hold more and more cash as reserves.

This chart from the Financial Times is an old one but good enough for our purposes. It shows how the reserve requirement (RR) for large banks increased over the past decade from around 7.5% to over 20%. The recent move brings it down to 19%.

So, thinking about it simplistically, the RR went up as China’s foreign exchange levels (and domestic bank reserves) went up. But now, that trend could be changing.

Bloomberg reports that in the fourth quarter of 2014, capital outflows in China were the largest since 1998. That’s not as extreme as it sounds, because it wasn’t a huge amount (US$90 billion), but it is unusual.

It suggests that speculative capital sitting in China hoping for a yuan revaluation might be starting to leave. This is a drain on domestic liquidity. When your economy is suffering from a credit binge hangover, liquidity constraints aren’t welcome.

As far as I can tell, the RR cut reflects an attempt to maintain liquidity and offset the effect of capital flight, rather than act as a monetary stimulus.

The bad news is that you can probably expect to see capital continue to leave China as the yuan’s peg to a dollar bull market takes its toll on China’s economy. The good news is that China has considerable defences against this and can lower the RR for some time to come.

The message? Don’t get too excited. China is in a long fight to keep its economic head above water after an epic credit boom.

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing.
He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’.
Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors.
And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand.
When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.
Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis.
Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy.
With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock.
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